The European Leaders agreed in principle at their meeting in Brussels on the 8th/9th of December 2011 to adopt tougher sanctions on the euro area countries that break the ‘new’ rules of what used to be the Stability and Growth Pact (SGP), what is now called the ‘fiscal compact’ (FC). The FC requires that tax and spending plans be checked by European officials before national governments intervene. There will be automatic actions against those countries that are deemed to have budget deficits that are too large. In effect the new agreement tightens the rules of the old SGP, but with no apparent improvement, as the FC retains the principles of the previous SGP but with the one addition that breaking the deficit rules may actually be punished in some way.

The limits of the fiscal compact (as in the SGP) are in effect to balance overall budget over the cycle and limit the national budget deficit in any year to a maximum of 3 per cent of GDP. Under the fiscal compact the 3 per cent limit is retained, and the balanced overall budget is formulated as ‘structural budget’ to not exceed 0.5 per cent of GDP, and this is to be written into national constitutions or equivalent. In place of the previous threat of a 0.2 per cent of GDP ‘fine’ for exceeding the 3 per cent limit (though never implemented even though there were 40 cases where the 3 per cent limit was breached), there will be automatic consequences, including possible sanctions, unless a qualified majority of euro area countries is opposed.

It is readily apparent that the ’fiscal compact’ does nothing to address the perceived problems of national governments with large budget deficits, which cannot be funded through capital markets, except insofar as it somehow changes the European Central Bank’s attitudes to directly or indirectly funding those deficits. More seriously it does nothing to address the major problem of the Economic and Monetary Union, namely the large current account imbalances – ranging from a surplus of 7 per cent in the case of Germany to deficit of 10 per cent in the case of Greece (figures for 2010).

Before considering the commitment into a national constitution, one should examine carefully whether a country can ever achieve a ‘balanced structural budget’. Some countries may, but others may not, yet this is being imposed on all. Consider what a balanced structural budget means: at a level of output, which is deemed to be potential (or others such as corresponding to a high level of employment) government revenue and expenditure are to be in balance. In turn this implies that private investment equals private savings plus capital inflow (equal to current account deficit) – and that this equality holds at potential output and that the equality holds for the intention to invest, intention to save, etc. It is not that the equality holds at some level of output but at the specified level of potential output. Some neo-liberal economists may believe that saving and investment intentions can be aligned at potential output (or full employment), but where is the evidence?

There is a clear lack of symmetry here – structural deficits cannot be more than 0.5 per cent, but any level of structural surpluses is allowed. Those countries which have conditions conducive to budget surpluses, such as strong net exports and high rates of investment, can have such surpluses; those which have conditions requiring budget deficits to sustain demand, net imports and high levels of savings relative to investment, cannot deploy deficits.

The ‘fiscal compact’ assumes that an upper limit of 3 per cent of GDP is consistent with a near balanced structural budget despite the swings in economic activity and associated swings in budget deficits as the automatic stabilisers take effect. As a rule of thumb a 1 per cent fall in GDP below trend leads to around a 0.7 per cent rise in the budget deficit – hence a more than 3 per cent drop in GDP before trend with a structural deficit of 0.5 per cent would lead to a country breaching the limit. Note that this is a drop in GDP below trend – and could come from an actual drop of more like 1 per cent (with a 2 per cent trend growth rate).

The implication of automatic sanctions is that the sanction is applied whenever the budget deficit exceeds 3 per cent of GDP, whatever the reason. A shortfall in demand, a financial crisis which brings recession, the need to respond to a national disaster are not apparently to be allowed. The aim of a balanced average (‘structural’) budget is actually a significant budget surplus when calculations are made (as they should) in real terms; that is with allowance for the impact of inflation on real value of government debt. But more significantly it would involve a very substantial excess of tax revenue over current government expenditure (excluding interest payments). Further, it makes no allowance for governments to be able to borrow to fund public investment. The profoundly undemocratic nature of this approach is clear – the unelected European Commission can ‘request’ that the elected national parliament and government to change its budget. It is also undemocratic in that it would seem to prevent a political party putting forward a Keynesian economic manifesto; even a programme including the ‘golden rule’ (borrowing for public investment) would be ruled out by the EC.

The ‘fiscal compact’ is anti-democratic and seeks to impose balanced structural budgets, which often cannot be achieved and which will further unleash the forces of fiscal austerity.

Philip Arestis is the Director of Research at the Cambridge Centre for Economic & Public Policy and Senior Fellow in the Department of Land Economy at the University of Cambridge, UK, and Professor of Economics at the University of the Basque Country, Spain. Malcolm Sawyer is Professor of Economics at the University of Leeds, UK.